Saturday, May 8, 2010

My valuation of Mannkind corporation


At the heart of every buy/sell decision of a stock is the valuation. If valuing a company with predictable earnings is fraught with risks, then any valuation of a biotech company without past earnings is speculative at best.


How to value anything? The first attempt to give a theoretical approach to valuation was given by John Burr Williams, in his Harvard doctoral thesis around 1937. He also published his book “The theory of Investment value”. He certainly was not the first to give an approach, but he made his approach more popular. We can probably credit Aesop fables for the first valuation approach; “A bird in hand is worth two in the bush”. (I heard Warren Buffett say this, I hope this is true).


So John Burr Williams stated “for a common stock, the intrinsic, long-term worth is the present value of its future net cash flows—in the form of dividend distributions and selling price.” It is not an exaggeration to say that in today’s world, all valuation modern financial instruments (stocks, bonds, derivatives, collectibles etc) are in one shape or form rest on John Burr Williams’s thesis. He also wrote a little jingle for the layman to understand.

Even so spoke the old farmer to his son:

A cow for her milk

A hen for her eggs,

And a stock, by heck,

For her dividends.

An orchard for fruit,

Bees for their honey,

And stocks, besides,

For their dividends

The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.”


When it comes to a sector like Biotech or any other sector, “Sell side Analysts” do influence the public thinking. Finding a good analyst is like finding the best dressed person in a nudist colony. You may not be happy with the one you find. I’ll explain the reason for my contempt for the analysts with an analogy. If you happen to live in California during the Gold rush & want to make money, will you depend on a publisher who prints a pamphlet that has a map showing the gold deposits or will you partner with the best Gold prospector who is prospecting with a tool worth a billion dollar? The best Gold prospector has also an enviable track record that is second to none. The choice is simple and obvious. So if an analyst is really worth his/her salt, he/she will not be peddling reports. They would have either setup a hedge fund or biotech firm or a biotech mutual fund. Now do you understand why Alfred Mann never became a sell side analyst of Pharma companies? So, one should read any analyst report with a grain of salt.


When it comes to Mannkind, the analyst’s price targets have varied from $1 to $28.00. I can also count many investors who are predicting $250.00. Who is right and who is wrong?. When it comes to valuation, Warren Buffett’s quote comes to mind. “It is better to be approximately right than be precisely wrong”. If any investor thinks that Afrezza is not going to succeed then they have no business investing in Mannkind at the moment (the oncology program may have some value, but the current price of Mannkind shares are dictated mostly by the changing fortunes of Afrezza). Given the plethora of published data on Afrezza, one can make a reasonable guess that Afrezza has a place in the market. The FDA uses the word armamentarium, I heard this for the first time. At least FDA is trying to find out where Afrezza fits in the big picture. Why would they talk about armamentarium if they are not going to approve it?


Mark Twain famously quoted "The return of my money is more important than the return on my money". I always keep this quote in mind when I look for stocks to invest. I had never invested in a Biotech stock until I came across Mannkind. I got curious about Mannkind some two years back when I read Bill Millers interview. Miller said the stock with the best appreciation potential in the next 10 years is Mannkind. Having read everything there is to read about Warren Buffett (includes books, articles, interviews, newspaper articles for last 40 years using proquest), I started seeing striking similarities between Buffett and Mann. Both are intensely passionate & dedicated to their work, both are well accomplished with an enviable track record, both have no interest in money and do not believe in handing down a life time of welfare checks to their kids, both have pretty much given their entire fortune to charity, both started business at an early age (Buffett was selling Pepsi at 5, Mann was selling Lemonade at 4), both worked so crazy hours that their wifes and kids practically abandoned them (Mann is in his fourth marriage, and Buffetts second. Buffett’s first wife left him for California when kids left), inspite of their Billionaire status, their living is relatively frugal. The list goes on and on. The most important of all is their integrity and honesty. As Buffett says, it takes a life time to build one’s reputation and an hour to destroy it. Both have that in plenty.


I started reading everything (many thanks to PubMed) I could about Mannkind and Afrezza. What ever I read started making sense. I decided to invest two/three years back and started at 12.85, promptly it started crashing. Believing Ben Grahams (the father of security analysis) saying “Market is a voting machine in the short term and weighing machine in the long run). Mr. Market started quoting all kinds of crazy prices. I started adding all the way down to 2. I’ve managed to average it to around 4.5.


Let’s come to the meat of the matter. How am I valuing Afrezza? We can not value Mannkind by P/E, P/B or Price to free cash flow. We’ve to make a big assumption on what potential market share it can take and then derive the valuation.


Some assumptions: the sales will start by Q1 of 2011, net margin of 35%, non-US sales roughly same as US sales (from Diabetes market outlook & this is conservative as emerging markets are having exploding growth in diabetes), discount future cash flows at 20% rate to account for risks.


I’m giving three scenarios, A, B & C. My approach to valuation is simple. I give no value for TI platform for other drugs, GLP1 etc. I will value everything other than Afrezza at 113 million dollars. (to be more conservative)


All numbers in Billions, USD.


Current RAA sales (lispro ~2B sales in 2010, aspart aka novorapid ~ 7 B sales & glulisine 0.75 B annual sales). The figures were obtained from each company’s IR presentation/annual reports. The world wide sales are roughly 10 billion and growing at 15%. We’ll assume a conservative 10% growth.

The valuations of Afrezza are given below. To get the Mannkind valuation, add $1.00 (~100MM/113MM shares) to the Intrinsic value.








(billions USD)






YEAR

2011

2012

2013

2014

2015

Worldwide RAA
sales ; 10% growth

10.00

11.00

12.10

13.31

14.64







Scenario 1: Most optimistic:
Afrezza captures 80% of market in 5 years






Potential market penetration rate

10%

25

50

75

100%

Afrezza sales

0.76

2.20

4.84

7.99

11.50

Margin

35%

35%

35%

35%

35%

Net Income after tax

0.27

0.77

1.69

2.80

4.03

Terminal value (2015 profit/10%):
Assume perpetual 4 billion ,
zero growth,
10% discounting.





40

NPV (@20% discounting)

20.88





Net to Mannkind after giving 30% to partners

14.616





total shares outstanding ~

0.112





Intrinsic value/share at end of 2010

130.5























Scenario 2: Conservative
Afrezza captures 50% of market in 5 years






Potential market penetration rate

10%

25%

50%

75%

100%

Afrezza sales

0.50

1.38

3.03

4.99

7.32

Margin

35%

35%

35%

35%

35%

Net Income after tax

0.18

0.48

1.06

1.75

2.56







Terminal value (2015 profit/10%):
Assume perpetual 2.56 billion ,
zero growth,
10% discounting.





25.6

NPV (@20% discounting)

13.2





Net to Mannkind after giving 30% to partners

9.24





total shares outstanding ~

0.112





Intrinsic value/share at end of 2010

82.5

















Scenario 3: Dooms day
Afrezza captures 10% of market in 5 years






Potential market penetration rate

10%

25%

50%

75%

100%

Afrezza sales

0.10

0.28

0.61

1.00

1.46

Margin

35%

35%

35%

35%

35%

Net Income after tax

0.04

0.10

0.21

0.35

0.51







Terminal value (2015 profit/10%):
Assume perpetual 0.51 billion ,
zero growth,
10% discounting.





5.1

NPV (@20% discounting)

2.44





Net to Mannkind after giving 30% to partners

1.708





total shares outstanding ~

0.112





Intrinsic value/share at end of 2010

15.25







It is fairly obvious that most analysts are expecting a market share of less than 10%. Many of the estimates have been conservative. I like Scenario 2. I’ll give a margin of safety of 50% and value Mannkind at ~ 40/share.


Update on May 10th regarding valuation
-----------------------------------------
I thought I should give some update to the valuation. Generally valuations come up with a million if's and but's and hypothetical scenarios that generally make it worthless. This is just a guessing game and future sorts out everything. As Buffett would say, you don't have to weigh a person to know if he/she is fat. The same thing applies for Mannkind too. So if you have to spend days working on excel to find if something is worth buying, then it surely is NOT. You should know enough to know if this product makes sense (or horse sense).

Ideally I should have come up with different scenarios and put some probabilities for each scenario. This is finance 101, something I picked up while passing CFA. The expected value is beautifully explained in wiki. I was just too lazy to do that. But will do it now.

So I can add scenario 4, where Afrezza sales is not much (say lung/cancer warning) and IV can be be 2$ per share. I'll put the probability of this at 10%.

So Expected value = Scenario 1 * p(scenario 1) + Scenario 2 * p(scenario 2) + Scenario 3 * p(scenario 3) + Scenario 4 * p(scenario 4); the sum of probabilities should be 1

= 130.15 * 0.15 + 82.5 * 0.50 + 15.25 * 0.25 + 2.0 * 0.10 = ~65.00

You should not put a margin of safety to this number as it includes all possibilities. You can play around with the probabilities and get any number you want. So now do you understand why each analyst comes up with a different estimate when they are presented with the same facts?

a) OK, first I start with some revenue projections. We can assume that sales will start by 2011. For a lack of a better term, I use the term "Potential market penetration rate". This is like sales ramp up, from the get go, you can not expect Afrezza to grab the market share, if I am assuming that by end of year 5, they'll grab 50% share of entire RAA, then that reaching of 50% will take time.
Overnight the doctors are not going to abandon their tried and true approach because the Afrezza salesman walked in. It takes time to grab the mind-share and market share. So in year one, I'm assuming that only 10% of potential is reached and I increase it to 100% in 5 years. It means in year 5, who ever can be converted to Afrezza will be converted.

b) The next one is DCF, discounted cash flow. here you apply time value of money. If you put $100.00 on Jan 1st and get 5% interest, then you get 105 by end of the year. So 100$ today is same as 105 dollars in a year from now. This 5% can be called risk free rate. To account for risk, folks add more %. Think of this, the credit card company charges an arm and leg for risky borrowers, it is simply because on the whole they want to make a decent profit accounting for the high defaults, collections etc. Here I'm putting 20%. The share price is after discounting the net income & terminal value.

Again some argue is it high and some it is very low as it is a risky bio tech company. I calculate the terminal value and discount back all the income. Here income and cash are used alternatively. I'm just assuming that the free cash flow is roughly net income as given.

c) Some have asked Why are you assuming aggressive sales estimates?
We are talking about a paradigm shift. Mannkind is not like a new pizza company competing against existing and well established Pizza Hut, Dominoes etc. In Al Mann's words, "This is a new class of rapid acting insulin". Exubera is not even in the class and it flunked the class it was in.

In historic context, we are talking about something like a Model T in front of "horse & buggies"




This is the core assumption in putting the sales estimate. I expect the existing market for RAA to be obliterated by Afrezza. Picture the battles in the book "Guns, Germs, and Steel: The Fates of Human Societies". Afrezza's attack on today's RAA will make Conquistadors look like sissy. The market capitalizations of Novo, Eli will flow towards Mannkind.